Mortgage Basics Part 1

A mortgage is just a fancy word to describe a loan that is secured by the property for which the loan was used for.  In most cases the loan is for a house or condo.  In the very strictest sense, a car loan is also a mortgage but no one ever calls it that.

housepicture.jpgThere are a few terms that you need to be aware of:

Amortization: this is the total number of years that the loan is structured for (example: 25 years). At the end of the amortization period, the loan will be fully paid off.

Term: While the loan may be for 25 years total, the term may be for a shorter duration and is usually 5 years.  The monthly payment amount and interest rate options are locked in for the length of the term. You will have many terms throughout the lifetime of your mortgage. Once one term ends, you re-negotiate the details for the next term of your mortgage.

Interest rate: This is simply the rate which the bank charges you to borrow money.

Principal: This is the total amount of money that you borrow.

Down Payment: This is how much money you already have available in cash to put towards the purchase of the house.  The difference between the purchase value of the house (e.g. $250,000) minus the down payment (e.g. $12,500) equals the amount of mortgage you will need (in this case $237,500). (There may be some other costs added to the mortage – usually in the few thousand dollar range.)

So to give a full example: Bob would like to buy a house which is being sold for $200,000.  He has saved up $50,000 for his down payment, so he will require a mortgage of $150,000. He decides to choose an amortization of 25 years (so the mortgage will be paid off after 25 years). He negotiates a 6% interest fixed-rate for a 5 year term so he knows that no matter what happens to interest rates in the economy his payments will remain static month to month for the duration of the term (5 years). His monthly payment is $959.71 for the next 5 years.

At the end of his term, it is time to renegotiate for the next term.  Interest rates have fallen and he is able to renew his mortgage for a new 5 year term with an interest rate of 5%. This reduces his monthly payments to $886 for the next 5 years.

It is important to note that if Bob averaged 6% interest for all 25 years he would be paying $137,913 in interest over the 25 years to borrow $150,000 now.  While this is depressing – it is hard to avoid paying so much in interest costs… which is why a lot of people will focus on paying off their mortgage as soon as possible.

 




Preet Banerjee
Preet Banerjee
...is an independent consultant to the financial services industry and a personal finance commentator. You can learn more about Preet at his personal website and you can click here to follow him on Twitter.
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